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Treasuries Not Good Enough as Swaps Collateral

Rule under consideration by CFTC would require Treasuries to be covered by lines of credit when used as collateral for swaps and futures trades.

Rules under consideration by federal regulators could require clearinghouses to back up Treasuries pledged as collateral in the $693 trillion over-the-counter (OTC) derivatives market with credit lines, according to industry executives.

The Commodity Futures Trading Commission (CFTC), moving to toughen safeguards in a market blamed for worsening the credit crisis, is weighing a regulation that would mandate Treasury collateral be subject to a “prearranged and highly reliable funding arrangement,” according to documents on its website. Federal Reserve officials told banks and exchanges that the language means bonds must be covered by credit lines, according to three industry executives briefed on the matter.

“CME estimates that liquidity facility costs would approximately double” if the rule is passed, according to a letter that CME Group Inc., owner of the Chicago Mercantile Exchange, sent to the CFTC. “These increased costs would likely either be passed on to end customers or cause many clearing members to exit the customer clearing business entirely.”

While Treasuries are considered to be among the safest investments, policy makers are concerned liquidating them will require too much time during a crisis—up to a day, according to a government official familiar with the Fed’s thinking. The 2008 financial crisis showed even that can be too long during times of stress. Back then, the Fed was forced to give out more than $2 trillion in emergency aid.

“This requirement is that a clearinghouse be able to take your collateral if you post it—Treasuries or anything else—that they have rapidly available ways of transforming that into cash,” Gary Gensler, chairman of the CFTC, said during an interview in New York today. While he doesn’t envision the rule putting a dent in the Treasury market, “there is some cost to the clearinghouses,” he said.

Gensler said the CFTC’s four commissioners will finalize the rule tomorrow by private vote. Changes to its wording are possible up until that point. Barbara Hagenbaugh, a spokeswoman for the Fed, declined to comment.

The CFTC is working with the Fed on the rule because the central bank has a regulatory role, mandated by the 2010 Dodd-Frank Act, to oversee systemically important financial institutions such as the major U.S. derivatives clearinghouses. International regulators last year set broad standards for how clearinghouses treat the collateral they hold against a member default.

Sweeping Changes

The revised treatment of Treasuries as collateral would also apply when they are pledged to protect futures trades at U.S. clearinghouses.

While the CFTC vote would finalize the detailed version of the mandate, it wouldn’t guarantee the Fed’s interpretation prevails. Fed officials will accompany the CFTC during oversight and enforcement reviews of derivatives clearinghouses, and central bankers could insist on proof that lines of credit back the Treasuries posted as collateral, according to one person familiar with how the process works.

The Dodd-Frank Act required most swaps to be backed by clearinghouses for the first time after the contracts helped cause and intensify the credit crisis of 2008. That means swaps users will have to post $800 billion to $4.6 trillion in additional collateral at clearinghouses to meet the new regulations, according to estimates from the Treasury Borrowing Advisory Committee.

Stiffening funding requirements for Treasuries would be the latest in a series of actions taken by regulators to rein in the swaps market, frequently to the dismay of traders who say the rules make it unreasonably difficult to do business. The goal is to avoid meltdowns like the ones in 2008 that triggered American International Group Inc.’s $182 billion bailout after the insurer couldn’t make good on its trades and almost destroyed the world’s biggest banks.

Most Natural

CME Group, the operator of the world’s largest futures market, said the proposal risks damaging the perception of U.S. national debt as easy to buy or sell, according to a Sept. 16 comment letter to the CFTC from Kim Taylor, president of company’s clearinghouse.

“To assert that U.S. Treasuries can only be considered ‘liquid’ to the extent that they are utilized with pre-arranged and highly reliable funding arrangements is to assert that the liquidity of U.S. Treasuries is ‘zero,’ which seems unnecessarily extreme,” Taylor said in the letter.

Treasuries are the most natural form of collateral for banks and their customers to use to back derivatives trades, CME Group’s Taylor said.

“Treasuries are normally very easy to convert into cash on a same-day basis” even if “the cash need not arrive until the end of the day,” Darrell Duffie, a finance professor at Stanford University, said in an interview. While CME Group survived multiple rounds of margin calls over a single day after the 2008 bankruptcy of Lehman Brothers Holdings Inc., one of the largest derivatives dealers at the time, “I suspect it was a tense day,” Duffie said. Having assured access to cash in place of Treasuries could be important for the industry, he said.

The Futures Industry Association, a trade and lobbying group for the banks that act as brokers in the industry, asked the CFTC to allow Treasuries to be pledged without any financial backing, according to a Sept. 20 comment letter to the CFTC.

“U.S. Treasury securities are generally deemed to be ‘high quality liquid assets,’ as defined by the Basel Committee on Banking Supervision—i.e., unencumbered cash or assets that can be converted into cash at little or no loss of value in private markets,” the FIA said in the letter.

CME’s Collateral

Clearinghouses, which are capitalized by their bank and brokerage members, are meant to lessen the effect of a default by requiring collateral and marking positions daily so losses don’t snowball. Initial margin is pledged to fund a potential default, while variation margin is required when positions lose value. If investors can’t meet their margin calls, the positions are liquidated.

CME Group increased the size of its credit line to a maximum of $10 billion from $7 billion, the company said yesterday. Banks including Deutsche Bank AG, Citigroup Inc., Barclays Plc and Wells Fargo & Co. have agreed to loan the money, which CME Group could use during times of stress.

Even the new credit line is less than the $14 billion exposure that CME Group has to its largest bank clearing member, according to a person familiar with the matter, who asked to not be named because the details are private. CME Group doesn’t disclose how much of its collateral is made up of Treasury securities.

Laurie Bischel, a CME Group spokeswoman, declined to quantify the company’s exposure to potential losses in the event its biggest member defaults. She said the collateral held at the clearinghouse is sufficient to cover the two biggest member defaults.

CME Group said in its letter to the CFTC that it may be unable to secure a credit line exceeding $10 billion. The total committed credit facility market is made up of 1,800 arrangements that total about $1.2 trillion, with only 12 of those equal to or exceeding $10 billion, the company said.

“The obstacles to CME obtaining committed liquidity facilities large enough to cover its liquidity requirements will only be exacerbated in the future as the cleared OTC market grows, which in turn will increase CME’s liquidity resources obligations,” the exchange operator said.

In a sign of the interwoven nature of the derivatives market, the banks that tend to provide lines of credit to clearinghouses are also the same firms that are required to post collateral there.

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